Roth IRA CD: Penalties on early withdrawal

Dear Dr. Don,
Is it possible to withdraw money from a one-year Roth individual retirement account certificate of deposit before its maturity date? I’m wondering if there’s an income tax penalty that I’d have to pay. What more do I need to know about the likely tax hit?

Thank you,— B.P. Penalties

Dear B.P.,
It is possible to withdraw the money, but there are three potential income tax-related penalties. These include: the interest penalty for early withdrawal charged by the bank, an early withdrawal penalty tax when the owner takes a distribution before age 59 1/2 and potential income taxes imposed on a nonqualified distribution.

Let’s handle the bank (or where you have the account) first. Banks will often waive the interest penalty for early withdrawals when the withdrawal is made to meet the federal government’s required minimum distribution rule. Roth IRAs don’t have required minimum distributions, so the bank doesn’t have a reason to waive the interest penalty. Still, it doesn’t hurt to ask.

The 10 percent penalty tax for early distribution before age 59 1/2 is a bit more complicated. Distributions of investment earnings made before age 59 1/2 are subject to the double-whammy combination of penalty tax and income taxes.

Finally, the Roth IRA has a so-called account seasoning requirement of five tax years before distributions fall into the “qualified” category. Early distributions of investment earnings that are also nonqualified distributions may bring about both the penalty tax and income taxes.

At issue with the seasoning requirement is when you first established and contributed to a Roth IRA. Although this is a one-year CD, the five-year requirement could still apply. A tax professional can help you figure this out.

Ordering rules for distributions require you to take out regular contributions first. That’s followed by conversion and rollover contributions and then the earnings on contributions.

The tax penalties and income taxes focus on investment earnings. The good news is that a one-year Roth IRA CD won’t likely be earning much interest. As a result, an early withdrawal penalty may not amount to much. The customer service representative at the bank or financial service provider should also be able to give you more information.

By looking into the matter, you’ve taken the first step toward keeping the IRS happy.

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